After years of debate and delay, implementation of the new revenue recognition and lease accounting standards are finally in view. The new standards, issued by the Financial Accounting Standards Board (FASB), are the result of years of study on how to improve accounting in these areas. You know the guidance will have an effect on your financial statements, and that the impact may be significant. But whether it’s making touchdowns or making widgets, changing the rules of the game also means changing the way the game is played. How will the new rules affect your existing sales contracts and lease agreements? What should you do about it? And how will the new rules change the way you negotiate sales contracts and handle leasing decisions in the future?
Moreover, the new guidance changes the numbers used in calculating key financial metrics, which can give you different results for return on assets, working capital, and so forth. Financial metrics are integral to many kinds of agreements, ranging from bank loans to compensation. How do you manage, now and in the future, this impact from changes in your key metrics?
As the new accounting rules start to take effect, let’s take a closer look at what the impact will be on your key business agreements, and what you should do about it. Note that our discussion will be based on U.S. accounting; international guidance has also been overhauled, with some differences.
Revenue recognition and sales contracts
The new revenue recognition standard (commonly referred to as ASC 606) goes into effect for public business entities in 2018 and all other entities in 2019. The new guidance replaces many specific rules with more general principles. It also replaces much of the industry-specific guidance your organization may now be using.
You will recognize revenue using these steps:
Establish that you have a contract with your customer.
Determine what you’re giving the customer, identifying each promise you’re making.
Figure out what you’re receiving for what you’re doing.
Allocate what you’re receiving in proportion to each promise.
Recognize revenue whenever you deliver on a promise.
That summary makes a very complicated process sound very simple: sometimes, just deciding whether and when you have a contract with your customer can be mind-numbing.
The outcome is that the timing of revenue recognition for organizations will change, if by varying degrees. You’ll want to review key elements of your existing customer contracts — what are your obligations, when must they be delivered, when do you get paid, etc. — in light of the new guidance.
Sometimes, you’ll find one or two contract terms that have a big effect on when revenue is recognized. You may or may not have the ability to modify them, or even want to. But at least think about whether it’s worthwhile to ask the customer for changes to those terms. And as you enter into new contracts, consider the various effects on your financials: especially on revenue, but also accounts receivable, inventory, and so forth.
The new lease accounting rules (commonly referred to as ASC 842) go into effect for public business entities for 2019 and all other entities in 2020. Lessor accounting hasn’t changed much. The main difference is for lessees: all leases (both finance and operating) will appear on the lessee’s balance sheet (leases less than 12 months excluded).
That’s a big deal: Operating leases will no longer be a way to get off-balance sheet financing (OBSF). Lease vs. buy analysis gets a new twist: Getting OBSF has often trumped other considerations and made getting an operating lease, where possible, a no-brainer.
Lease classification will still have significance for earnings: Operating lease expense will be straight-line, while for finance leases, it’s more front-loaded and shown as interest and amortization expense. This difference in treatment might be outweighed by traditional business factors — financing cost, risks and rewards of ownership, new technology, etc. — which will now determine whether companies opt for an operating lease or finance lease, or conventional purchase. Acquiring long-term assets will now focus on business benefit instead of accounting advantage.
Similarly, often the primary purpose of sale/leaseback transactions was to get OBSF for lessees, especially for real estate. With that incentive gone, organizations will now shift focus to the business reasons for doing a sale/leaseback to see if it’s worthwhile.
The new rules change sale/leaseback accounting in intertwining ways. Both lessor and lessee will use the revenue recognition standard to determine if a sale has taken place. The guidance will in fact make it easier to qualify real estate for a sale. Then, the leaseback falls into the new leasing standard. If you do decide to do a sale/leaseback, you may want to expedite implementation of the new leasing rules so both of the standards are effective at the same time.
Agreements where financial metrics are key
The new revenue recognition and lease rules will change key financial metrics like EBITDA or ROA, in some cases, substantially. What should be your general approach to existing agreements where the new rules affect your metrics significantly? In general, agreements are written under either floating GAAP, where the contract has provisions to incorporate new accounting rules, or fixed GAAP, where it does not. Sometimes, the agreement is completely silent about accounting changes. And even floating GAAP may have ambiguities on how the rules are applied, or may not cover terms that have become more important to you.
So, whatever the agreement, organizations should look through them, determine what the impact will be when the new rules come into effect and, if significant, have discussions with the other parties. Clarify with them what the impact might be, and discuss how the contract could be modified to take the new standards into account.
For agreements that are going into effect between now and the standards’ effective dates, you should make it clear how metrics will be measured under the new rules, or provide for revisiting the issue upon adoption.
For agreements entered after the new rules take effect, make sure that any terms from a predecessor agreement have been updated to reflect the newly adopted guidance.
Bank loans commonly carry covenants that specify key financial metrics the borrower must maintain at certain levels. The metrics often include EBITDA, which may well be affected by either of the new standards. The new revenue recognition guidance could also change accounts receivable and inventory balances, which could affect your borrowing base. And with operating leases now on the books, assets and liabilities could increase, with ramifications for ROA, debt-to-equity, and other ratios.
Assuming your banker knows you and your business, accounting changes don’t ordinarily have a substantial impact on your borrowing. Still, if there is a significant impact on some of your key ratios, you should reach out to your banker and discuss the effects of the new rules.
Business purchase agreements
Business purchase agreements transfer ownership of a business from a buyer to a seller. The new accounting rules could be a factor in key elements of the agreement:
Working capital. Accounting changes that also impact inventory, accounts receivable, etc. would affect working capital balances.
The purchase price. It’s often based on a multiple of earnings, which, notably, is impacted by a change in revenue.
Earn-outs. When negotiating earn-out payments to be made to the seller based on performance of the business following the purchase, you need to understand the implications of accounting changes. Performance is often measured on sales or earnings, or a profitability ratio, like ROA. The accounting staff should be involved, or at least kept informed, of the discussions.
These issues are unlikely to threaten the deal. Still, problems may arise, particularly when you’re at the cusp of implementing the new accounting. It’s worthwhile to discuss these matters and the impact of the new rules to ensure all parties are on the same page.
Other business agreements
There are numerous other business agreements to which financial metrics are essential and must be similarly monitored in light of the new guidance:
Compensation agreements for senior officers and other employees will contain a variety of arrangements and incentives — including bonuses, deferred compensation, and stock options — that may depend on meeting financial targets.
Stockholder agreements may include redemption or exercise provisions similarly based on financial metrics. The one wrinkle in this area is that, if there are a number of stockholders, how you communicate becomes crucial in dealing with a group of people.
The new revenue recognition and lease standards will not only affect your accounting: They will also affect the way you do business. The impact will surely be felt in sales contracts and leases. But the effect will also be seen on agreements where financial metrics are important, like bank covenants.
Organizations need to review their current agreements to make sure the accounting changes don’t have consequences the parties never intended. They may also want to ask for changes in some agreements, sales contracts being a notable example. Entities should negotiate new agreements before implementation, fully aware of the accounting impact that will be forthcoming. And post-implementation, organizations should continue to monitor accounting developments so that new agreements are made in light of current guidance.